Yesterday Governor Schwarzenegger held a press conference in Fresno to talk about the horrible situation facing many, many California families who opted to take out sub prime loans to afford their homes, only to find that with a downward shift in the economy, the adjustments coming in the interest rates for those loans will lead many of these borrowers to default on their payments, and lose their home.
At the event, the Governor announced that he had negotiated with lending companies (representing 25% of existing home loans in California) who have agreed in some manner to not implement the scheduled hike in interest rates for some home owners. It is still unclear exactly what this means at this point, as the details are a bit vague. It sounds like in those instances where someone is still making their payments, and can demonstrate to the lender that they can afford to continue to make their current level of payment, but cannot afford an increase, the lenders may ‘cut some slack’ as it were, and leave the existing rates for a while.
Let me say that this entire sub prime mortgage issue is a major one, and one with a lot of very real potential tragedy involved. It is certainly appropriate for leaders in government and in business to raise the issue, and dialogue about what things can be done to try to minimize the negative impacts.
That said, I would merely take the opportunity to be a voice of caution. There is such always a tremendous risk when government interferes with the natural course of the free market. There is a very fine line between government regulation, and "negotiation" lead by government policy makers that create an environment where those being "negotiated with" take actions that they otherwise would not do, but for fear that in the absence of being amiable, they might, in fact, face very real onerous government regulation.
From listening to the press conference, it seems like this is not some sort of ‘wholesale’ freezing of rates by lenders. It sounds like there is a commitment to really treat homeowners who are endangered with kid gloves, and try to work with them to keep them from losing their greatest asset — their home!
But I would actually lean on some thoughts penned by Sacramento Bee columnist Dan Weintraub as to why we actually do NOT want any kind of wholesale subsidy of at-risk homeowners by mortgage lenders by freezing their rates. To provide a little bit of context, Weintraub’s piece is an effort to address a proposal made by the head of the Federal Deposit Insurance Corporation, mandating a freeze on loan rates made to so-called sub prime borrowers. Whether it is mandates, or "coercively negotiated," it is a bad idea in the big picture. As Weintraub says, this action, "would actually hurt potential homebuyers who stayed out of the red-hot market rather than buying a home they could not really afford."
The following bullet points are excerpted directly from Weintraub’s column:
- Each loan is a binding contract between a lender and a borrower. The lender has given up some money that could have been invested elsewhere, and the borrower has agreed to pay a certain interest rate for the use of that money. Included in that rate is a risk premium. The less reliable the borrower, the higher the price they have to pay for the money, to compensate the lender for the higher likelihood that some of those loans will never be repaid.
- If, suddenly, that agreed-upon interest rate is unilaterally lowered, the contract held by the lender is, if not worthless, seriously devalued.
- Few people care about lenders losing money. They are not exactly sympathetic characters. But follow that money a little farther along its path. Many of these loans were packaged and sold to investors as securities. By putting their money on the line, those investors were the ultimate source of the capital that allowed millions of people with low incomes or spotty credit records to buy a home.
- An across-the-board write-down of those loans would wreak havoc on the securities industry, causing an overnight loss of billions of dollars of value in the investments they hold. It would also send an ominous message to anyone thinking of investing in the mortgage market in the future: your money is not safe here. Future investors would thus require an even bigger premium to part with their money for mortgage loans. The end result? Less money in the mortgage market, less money to lend and higher interest rates for everybody.
- While a few people who borrowed more than they could afford would get relief, others who sat out the housing boom because they were more prudent would be penalized. While they saved money for a down payment on their first home, the higher interest rates caused by the bailout would mean higher housing payments for the same-sized loan, further postponing their ability to get into the market.
- One of the effects of foreclosures is downward pressure on housing prices. The bubble financed by these easy loans pushed the price of housing out of the reach of many prudent first-time buyers. The current decline, while painful to some, is a correction that eventually will make homes affordable again and bring more people into the market. Freezing interest rates at below-market levels would prop up the price of those homes. That’s great for anyone who already owns a house, but it’s a blow, again, to those who sat out the boom hoping that they could buy a home when normalcy returned.
It is important to remember, at the risk of sounding insensitive, that those people who are currently at risk of losing their home are not "victims" — they are, as Weintraub points out, "…adults who made a bad decision."
No one wants to see those who may have overreached lose their homes. But at the same time, we also don’t want to, in essence, reward these folks at the expense of those who were more prudent in their business decisions.
I will close by saying that the Governor’s encouragement of a process that treats each person negatively impacted by this situation as a person, not a number, is laudable. We should be doing everything possible to counsel those who are facing a severe economic challenge. It is also important to remember that lenders to not want to see defaults, either. So everyone working together is a good thing. But caution is called for, lest we take steps that ultimately do more harm, than good.
UPDATE: Dan Weintraub blogs on this topic here.
Care to read comments, or make your own about today’s Daily Commentary?
Just click here to go to the FR Weblog, where this Commentary has its own blog post, and where you can read and make comments.